Unit 2 – The Allocation of Resources
Chapter 2.5 – Price determination
Market equilibrium
The equilibrium price (also known as the market-clearing price) is determined where the
demand for a product is equal to the supply of the product. This means that there is neither
excess quantity demanded nor excess quantity supplied at the equilibrium price.
If price is set too high (above the market-clearing price), then supply will exceed demand.
This results in surplus production known as excess supply. In order for firms to get rid of
their excess supply (shown by the distance between Qs and Qd), they will need to reduce price
(from P1 to Pe).
By contrast, if the selling price of a product is set too low (i.e., below the equilibrium price),
the demand will exceed the supply. This creates a shortage in the market, caused by the
excess demand. At a price of P1, the demand is Qd while supply is only Qs so demand exceeds
supply. The excess demand causes prices to rise back to the equilibrium price of Pe.
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